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Economic Forecasts

Fed Acknowledges Slower Recovery But Stays Confident

Federal Reserve policymakers change course only slightly after tipping their hats to disappointing data.

The Federal Reserve took a modest step to stimulate the economy but remains essentially in a holding pattern. The latest missive from the Federal Open Market Committee (FOMC), the Fed’s policy setting panel, acknowledges what others have been saying for some time: “The recovery in output and employment has slowed in recent months.” But the Fed took only a baby step toward addressing that weakness, stopping well short of what some were looking or hoping for.

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The economic slowdown during the May-June period, with a possible extension into July, has been evident in a number of economic indicators: Home sales collapsed, employment growth slowed, and consumer spending gains cooled. While acknowledging these unpleasant realities, the Fed still predicts “a gradual return to higher levels of resource utilization in a context of price stability, although the pace of economic recovery is likely to be more modest in the near term than had been anticipated.” Basically, this translates into, “Look, we know this is disappointing, and it may linger a bit, but the basic outlook -- that of a recovering economy -- remains intact.”

Leaving it at that, however, might have come across as complacent. After all, forecasting is always risky, and erring on the side of caution is very much the Fed’s style. Accordingly, it made a small modification in one aspect of monetary policy: balance sheet management.

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Between November 2008 and March 2010, the Fed bought roughly $1.7 trillion of long-term bonds, mostly mortgage backed securities. This tended to push down interest rates (more demand for bonds means sellers don’t have to offer as much incentive) and to put cash in banks (payment for the bonds has to go somewhere). Since March, however, the Fed’s bond portfolio has been shrinking because of the natural maturation of its holdings, partly reversing its previous portfolio building strategy.

Given the renewed economic softness, some analysts have since argued that much more needs to be done, even suggesting that a program to buy more bonds would be announced. Instead, the Fed made a modest maneuver in this direction without going all the way. It said that cash proceeds from maturing securities would be recycled back into long-term Treasuries. Hence, the portfolio won’t shrink, as it otherwise would have, but neither will it increase. In essence, the Fed is in a holding pattern, waiting for new information before committing one way or another.

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One member of the FOMC dissented, however. Thomas Hoenig, the Kansas City Federal Reserve Bank president who’s been leading the hawks all year, argued that the expansion remains on track and emphasized the risks of too much easing.

If the recent weakness proves to be protracted, the Fed will surely move further in the direction set Tuesday, with net bond purchases increasing later this year. That is not our expectation, however. More likely, the recent soft patch reflects a litany of short-term problems, including fading tax benefits (for housing and energy efficient appliances), expiring jobless benefits (though since reinstated) and dismissed Census workers. Therefore, we expect the holding pattern to persist until that interpretation is validated, probably in the next couple of months. Then the Fed will resume talking about its “exit strategy,” which was where things were trending until a few months ago.

So here’s the most likely progression of events. First, the holding pattern will persist until the Fed’s November or December meetings. By then, the expansion’s endurance should be clear. At that point, the Fed will cease recycling mortgage backed securities and let the portfolio naturally diminish. Next, perhaps in April or June of 2011, it will start moving on the exit strategy more aggressively, with interest rates beginning to ascend. Look for the federal funds interest rate to remain at its present level -- 0 to 0.25% -- until mid-2011, but to rise to 2% by the end of 2011.

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